The 401k: What Would Jesus Do?

And God called to him from within the bush. “Moses, Moses!”And Moses Said, “Here I am, Lord”And God said, “Always contribute at least enough to your 401k to get your employer match. It’s like free money!”

It’s literally the most popular advice in personal finance. And you wonder why you’re paying a financial advisor when such popular advice is sitting right there in the Good Book. 89% of us have access to a 401k (or similar 403(b) or 457 plans) at our employer. About three in five 401k plans have a company match at an average of 2.7%. The thinking goes, if you don’t contribute at least enough to your 401k to receive the full employer match, then you’ll be ridiculed and scorned until my throat is sore.

I find that advice, in a word…bananas. Of course you contribute enough to get your employer match. However, you’d be crazy to not max out your 401k every single year.

Free Money is Free Money

For some reason, we always stop at “get your employer match,” as though that’s the only free money sitting out there. We seem to ignore the very obvious fact that every dollar deferred to your 401k (without a match) is “free money” as well, in the form of tax avoidance and equal to your marginal tax rate.

For most Americans, this is a guaranteed, risk-free, overnight 15% return on your investment. For upper-middle class Americans, the guaranteed return jumps to 25%. The higher up the income ladder, the higher the guaranteed return through tax avoidance.

Why 401k’s Apparently (Don’t) Suck

This seems so obvious to me, but I guess not to everyone else. Even some very respected folks like James Altucher seem to think 401k’s are a scam. When I bring up 401k’s to fellow co-workers and friends, I get less salacious complaints, but complaints nonetheless. They tend to surround around a few ideas.

I Really Like My Paycheck – Me Too! That’s why I really like my 401k. Every dollar I set aside only decreases my paycheck by 75 cents. In other words, every dollar I contribute increases my net pay by a quarter.

I Can’t Afford It – I can sympathize, but you better be serious. “Serious” like, making-less-than-$40k-a-year-for-a-family-of-four kind of serious. When we were living in NYC for a year at (for that zip code) a poverty wage and spending twice our paycheck, I STILL maxed my 401k. I’ve done it every year I’ve been in the workforce. I don’t want this to sound preachy, but if you’re not maxing your 401k and are spending money on things you don’t need, you might need to adjust your priorities.

I Don’t Want to Wait Until I’m 59 1/2 To Get My Money – We’ve all heard the horror stories. Take the money out of a 401k before age 59.5 and it is subject to the double death blow of ordinary income taxes and a 10% early withdrawal penalty. The same such considerations go for Traditional IRAs, SEP-IRAs, and SIMPLE-IRAs, as well. The bulk of my retirement savings are (and will be) in a 401k and these IRAs. I guess it’s game, set, match for retirement at 34ish, right? Wrong. With some very simple, legal tax maneuvers detailed here, I’ll avoid paying both taxes and penalties. A quick guide:

Convert incrementally to Roth IRA during first few years of retirement;

Utilize standard deduction, exemptions, and child tax credits to eliminate all income tax liability at conversion;

Let sit for five tax years in Roth;

Withdraw converted amount from Roth penalty free.

Will Congress change this loophole in the next few years? Maybe, but it’s more likely such a loophole closure would be for high income earners before my family. However, a little thing called “legislative inertia” pretty much guarantees laws on the books will stay on the books for much longer than anyone thinks possible. Inertia is why it’s still illegal in my state of Virginia to have sex before marriage (somebody shoulda told me).

I Might Be In A Higher Tax Bracket Later In Life – Yes, you might be, but you probably won’t. Here’s a graph of how income taxes have fared over the last 40 years or so (Data Courtesy of the Tax Policy Center).Perhaps surprisingly, the average tax rate has gone down. It’s gone down significantly for the middle class and even slightly for the evil upper class. Will this trend continue? Will Congress swoop in and jack up taxes for my unassuming middle class family? By the sound of every politician ever, it’s a resounding “No.” And even if I’m totally wrong, it’s still a moot point. Any 401k balance that is withdrawn/converted will be taken down significantly through deductions and exemptions. A complete, across-the-board tax system overhaul would have to occur to derail this plan.

Fees! Fees! Fees! – Yah, fees suck. And 401k’s screw ya from two sides. The plan administrator charges a fee (on average, 1%), and the mutual fund you are investing in will undoubtedly have a fee/expense of its own (on average, between 0.5% and 1%). Let’s point out now though that you’ll be paying that second fee if you invest in funds, 401k or not. So, the 2nd fee isn’t really a mark against 401k’s as much as it’s a mark against managed funds. So, unless you plan on managing your own money (which, for most people, is a terrible proposition), then you’ll always be paying a fee. If you’re smart, you’ll just go straight to a Vanguard Index Fund (Tickers VTI or VIG are great ones), and then your fee will be as low as 0.05%. I guess I’m lucky; my employer covers the administrator fee, and my fund fee (S&P 500) is 0.5%. So, a guaranteed overnight 25% return on my investment in exchange for a 0.5% fee. I’ll take it.

Your Employer Match Is Just Offset By Lowering Your Salary – This one is courtesy of Mr. Altucher. He cites a Center for Retirement Research study that showed for each $1 of 401k matching, salary dropped by 99 cents. Good point. So, what are you options? Quit (well, yes, but that’s a topic for another day). If you take the job, you’re implicitly giving up the 99 cents. Soooo, I may as well contribute to my 401k and get the dollar back. Obviously bait-and-switch is a little misleading, but don’t hate the player, hate the game.

Other Reasons 401k’s Are Awesome

It’s the Definition of “Pay Yourself First” – If I recall my Bible Study years, right after the Word of God about always getting your employer match is Saint Christopher (Patron Saint of Regurgitated Financial Advice) exclaiming, “For all ye consumers, pay yourself first. For ye shall spend ye money ye has in pocket.” If you just have your 401k come out of your check before you ever see it, then its never available to spend waste. In this way, a 401k is even better than its stepsister, the IRA, which requires an action after funds are in hand.

It’s an Above-The-Line Deduction – Somewhere between your credit score and your social security number is the second most important number in your life, your AGI. Everything depends on AGI. Your AGI determines your eligility for certain benefits/subsidies, qualification for tax credits (like the AOC or Retirement Savers Credit), FAFSA, Obamacare Subsidies, and it sets the threshold for your >2% miscellaneous deductions or your >7.5% medical deductions. 401k and Deductible IRA contributions lower your AGI, which has only positive effects elsewhere in your financial life.

401k’s Make You Rich, I Tells Ya! Richer Than Astronauts! – (What Show?) Okay, 401k’s are a get-rich-quick scheme, but they are a key ingredient to a get-rich-quicker-than-you-realized scheme. More of your money (since, ya know, no taxes) starts compounding earlier in life. The nice hanging carrot of an employer match is just gravy. And, if you’re smart about your withdrawal strategy (taking withdrawals during your low-income retirement years, regardless of age), you can avoid most (or all) taxes on the back end.

Conclusion

I’ll go right out and say it. This article was a little more ridiculously written than most things I write. Perhaps its the time of day (middle of the night). So, I don’t mean to sound unjust in this advice. I get that some folks have their reasons for not deferring the max to a 401k. Perhaps you want to diversify with non-marketable assets. Perhaps you truly don’t have the excess income to do so. Perhaps you have a brutal fee structure, vesting schedule, and terrible options. These are valid reasons for easing off the 401k pedal, and that’s fine. However, for most people, access to a 401k could be taken advantage of more fully, and those are the folks I’m really trying to touch with this article. Forgive me for the soapboxy-ness.

That said, I really hope I’ve convinced some of you. It’s early in the year right now, so try to make a point of contributing as much as possible to your 401k. Make it hurt! You can always adjust downward the following month. Keep enough liquidity around in taxable accounts to serve as your emergency fund, but otherwise, use that 401k and stop paying so many darn taxes. If you can hit the full $18,000 (or $24,000 if 50 and older) then awesome! You’ll be richer for it.

When I retired, I put most of my money in taxable accounts and converted all of my 401ks to Roths (much smaller part of my portfolio). But I don’t think I can touch the 401k unless it is a qualified reason (college loan, medical emergency, etc).

Hey Alexander, I do keep up with your blog and that you choose to invest in real estate, instead. Not a bad idea, although a little diversification could help. The age restriction is a common theme among those who avoid 401k’s, but the loopholes are widely documented and completely legal. Most seem to dismiss them out-of-hand, but it’s really a rather simple procedure.

401k’s are great options for most people. Sometimes the investment options are pretty expensive. It would be nice if plans had to include a low-cost index fund option. Regardless, a nice match is enough of an enticement to participate.

Much of the negatives of today’s 401k can be negated if you roll the money to an IRA when you change employers (which happens a lot!). I’m not an advocate of leaving it in your old plan or rolling it to your new employer as so few 401k plans have great investment options.

If you’re in a relatively low tax bracket – and you don’t get a match – a Roth IRA is a great option. The tax savings lost (by not using the 401k) would be small compared to the lifetime tax savings of a Roth.

Eric I’m now going to just show everyone at work who tells me why they aren’t signing up for our 401k plan this article. My employer gives us a guaranteed dollar for dollar we put in with a discretionary amount (usually another 20 to 50 cents). With that people are always saying they can’t afford the 4 percent that is required to get it. Foolish people my friend foolish people.Tyler recently posted…Free Isn’t Always Free!

I’m planning to retire early (50-55) but not extremely early (I found this topic too late in life). My issue/concern with saving via pre-tax is the assumption that there will be room (via exemptions and standard deductions) to convert pre-tax to Roth. Does your advice change if someone has no room to convert pre-tax to Roth once they retire?? For example, my wife is disabled and as hard as that is, she does have SSDI (Social Security Disability Income) and income from a group disability policy when she used to work. So, even when I retire around (50-55) we will have a fixed annuity like/pension like stream of income coming into our home and my retirement savings will supplement that.

So, with SSDI, it does not take much “other income” to make your SSDI benefit taxable. And with the group disability policy paying (taxed as ordinary income), my exemptions and standard deduction room will always be offset by this income until my wife is 65. My thought, today, is that I should be saving via Roth and pay tax at our marginal rate of 15% simply because when I retire…I won’t be paying any tax at all. (SSDI + Group LTD policy (income offset by exemptions and standard deduction) + Roth).

However, I remain a divided man. Just this year I switched back to Pre-tax because of the convincing arguments laid out above.